The economic logic for foreign funds to invest in domestic debt instruments is withering away as yield differentials are narrowing fast, owing to a steep fall in the rupee, said a senior SBI official.

The official also said looking at the real interest rate and the macro fundamentals of the economy, the rupee has to depreciate by 5 per cent every year.

“The rupee fall is primarily due to (US Fed Chairman) Ben Bernanke’s statement of a possible QE3 slowdown. Also, the US interest rates have gone up of late. If you see yield of 10 year US treasury is more than 2.21 per cent.

Kumar further said while the 10—year benchmark yield in the domestic debt market is hovering around 7.3—7.4 per cent, arbitrage opportunity for the FIIs is fast squeezing in the domestic market because of higher hedging cost due to fall in rupee.

“So, the economic logic in investing here is not there as the hedging cost will be around 6 per cent for FIIs, prompting them to pull out their investment,” SBI deputy managing director and group executive for global markets P Pradeep Kumar told PTI during an interaction.

Currently, the US treasury note for 10 year hovers around 2.1 per cent, while it is around 7.3 per cent for Indian 10—year benchmark yield. However, when FII takes an exposure in Indian bond, it has to hedge against exchange rate risk, which comes around 6 per cent.

So, the effective return for FII comes to 1.3 per cent (7.3 per cent minus 6 per cent) as of now in Indian bonds, in comparison to 2.1 per cent offered in US 10 year Treasury note.

Kumar also said the rupee has to depreciate by at least 5 per cent every year on the basis of macro fundamentals. “In the long—run, the rupee has to depreciate because there is both interest rate and inflation differentials between the US and India,” he said.

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